The Sohn Investment Conference, New York, May 2019

ESG and shorts front and centre

Event review by Hamlin Lovell
Originally published in the June | July 2019 issue

For the first time in some years, roughly half of the investment ideas provided by speakers were shorts – and for the first time ever that I can recall, a handful were explicitly ESG-inspired. Some ESG policies remove stocks with low ESG ratings from both the long and short investment universes, while others view shorting such stocks as not only a source of alpha, but also a way to incentivise changing corporate behaviour.

ESG shorts 

Scott Goodwin, managing partner and co-founder of Diameter Capital Partners, trades the full gamut of credit from liquid to distressed, based on sector themes and macro views. He expects that plastic packaging could be the next demon vilified by ESG investors, since recycling is low, it takes centuries to biodegrade and kills dolphins and whales. On top of this China has stopped accepting US plastic. This could raise the cost of capital for plastic firms just as it has for tobacco firms. He is short of Plastipak unsecured bonds, which he perceives to be closer to equity risk than credit risk. The firm’s margins of 4% are well below peers at 10-12% and Plastipak could be the next shoe to drop as giants such as Nestlé move away from plastic packaging. 

Spencer Glendon, founder of Probable Futures, argued that human civilisation is based on stable climates and that financial models do not reflect unstable climates which are causing the Poles to melt. Higher temperatures, storms and droughts could threaten economic growth and physical settlements in areas from Florida to Mexico and India. Glendon is short of Floridan municipal bonds, mortgage-backed securities and banks with exposure to the sunshine state. 

For the first time in some years, roughly half of the investment ideas provided by speakers were shorts – and for the first time ever that I can recall, a handful were explicitly ESG-inspired.

Other shorts 

To the extent that increasingly teetotal millennials may help to explain slowing alcohol sales – and some ESG mandates exclude alcohol – shorting a wine company could be seen as having an ESG element. But the short thesis was based on financial factors. Bayberry Capital founder, managing director and portfolio manager, Angela Aldrich, believes the global wine market is not just going ex-growth, but is actually moving into decline (aside from the tiny premium segment). The largest two markets – China and the US – both face problems. In China, there is full line forcing, counterfeiting and e-commerce driving down prices while the US is seeing channel stuffing and disappointing results from in-house distribution. Aldrich expects that Australia’s Treasury Wine Estates, which has had a spate of senior management departures, will see lower earnings and valuation de-rating, and envisages 50% downside for the stock. 

Olympus Peak Asset Management founder and CIO, Todd Westhus, has constructed a short-biased capital structure arbitrage trade that he expects has far more upside than downside. He reckons a spread of two points between the secured bank debt and unsecured debt of Western Digital could blow out to as much as 50 points. Westhus contends that Western Digital faces secular and cyclical headwinds. Its legacy HDD technology is losing market share and losing its cost edge over SSD, while the more advanced SSD technology faces a new entrant taking the number of players to seven. Western Digital has high and growing inventories, a declining cash balance and Westhus’s worst-case recession scenario would see negative margins and EBITDA, bankruptcy, and no recovery for unsecured debtholders. Even under his best-case scenario, using consensus forecasts, the firm’s leverage would double.

Expert networks firm GLG (Gerson Lehrman Group) presented the Sohn Idea Contest, which was won by Tariq Barma, formerly an analyst at Parian Global Management. He believes that the economics of producing potato fries follows the same boom and bust pattern as other commodity markets, and will soon move from the feast to the famine stage. He expects that the recent surge in pricing and profit margins for potato chips will imminently be reversed as a supply response comes on stream, just as Lamb Weston’s contracts are about to expire. 

Healthcare costs are the largest cause of personal bankruptcy in the United States, and corporate bankruptcy could be the fate of an over-leveraged hospital firm, expects Firefly Value Partners LP portfolio manager, Ryan Heslop. He contends that Community Health Systems has over-extended itself partly because remunerating management based on the growth of EBITDA and revenues created perverse incentives. The firm went on an acquisition binge, paying an average of USD 604,000 per bed, but has recently been selling assets for as little as USD 177,000 per bed (per Heslop’s estimate) in order to deleverage. It is threatened by structural shifts from rural to urban hospitals, and from in-patient to out-patient care, and has under-invested in new equipment. It has also been criticised for “gouging” (swindling) patients by charging higher markups on drugs. The firm’s debt is now worth more than 30 times as much as the remaining tiny slither of equity, which is valued at USD 400 million, but could eventually be worth nothing, Heslop expects. He has first-hand experience of the US healthcare system, having received treatment for Crohn’s disease from Sohn family member, Doctor Norman Sohn.

Healthcare longs and shorts 

US healthcare provided fertile ground for both long and short ideas, which are of particular interest given the mission of Sohn, to treat and cure paediatric cancer. The US National Cancer Institute devotes only 4% of its budget to paediatric cancer, which is unique because it changes families as well as lives. Sohn Conferences have raised USD 90 million. Since Sohn started, cure rates from paediatric cancer have risen from 25% to 80%, albeit with some lasting side effects from the toxicity of treatments. 

It is potential side effects that have for now prevented Reata Pharmaceuticals’ kidney treatment, Bardoxolone, from obtaining FDA approval. But Bihua Chen, founder and portfolio manager of Cormorant Asset Management, thinks that the initial FDA results should be reconsidered. She believes that the clinical trials should be restarted and targeted to avoid certain patient types who may be at risk of heart failure. The treatment is intended to delay the need for dialysis, after which median life spans are only five years. If it is approved, she projects USD 5 billion per year of sales, and a valuation for the firm of USD 25 billion, which would be ten times the current level.

The Longevity Fund founder and partner, Laura Deming, was a child prodigy who matriculated from MIT at the precocious age of 14. She now argues that the ageing process can not only be arrested but also reversed, based on experiments with worms, beetles and mice. She is long of stocks including Precision BioSciences Inc, and Unity Biotechnology Inc, which is engineering genomes, and did an IPO last year.

If longevity could breach new frontiers, US healthcare costs need to be controlled: extrapolating recent healthcare inflation would result in average healthcare costs surpassing average incomes in just 14 years, according to Dr Joon Yun, president and managing member of Palo Alto Investors.

The debate over healthcare funding and the polarisation of US politics is bifurcating valuations. US hospitals and HMO chains such as HCA Healthcare, Humana Inc, UnitedHealth Group Inc, Tenet Healthcare Corp and Cigna Corp are trading as low as single digit PE multiples on fears of a single payer healthcare system. This is a laudable goal, but its probability is almost infinitesimal, according to Glenview Capital’s founder, portfolio manager, and CEO, Larry Robbins. Only three Democratic candidates support the idea; 15 Democratic Senators oppose it as do three key Chairs; state budgets are stretched, and the second largest employers in many states – community hospitals – would be pushed out of business. Even if a single payer system did eventuate in the US, the experience of countries such as Canada and South Korea suggests that private insurance would coexist. Robbins does however expect drug companies could face tighter regulation, as Democrats and Republicans agree that drug prices are too high, and the CMI gives the President power to make mandatory changes. Robbins owns three pharma companies but is short of 16 that have high multiples, a large spread between US and non-US prices, and biosimilars. He is also short of two firms with potential contingent liability for toxic chemical PFAS – 3M and Chemours, and expects 3M might have to pay out as much as $6 billion in relation to litigation.

ESG long 

Lauren Taylor-Wolfe’s Impactive Capital combines traditional activist tools – around capital allocation, capital structure, operational and strategic matters – with a desire to bring about ESG improvements. Wyndham Hotels and Resorts satisfies her business criteria, given its leading 40% market share of branded economy and midscale hotels, which are resilient in downturns, and have seen the least supply growth of any segment. Wyndham also trades at a discount to peers and Taylor-Wolfe sees 50% share price upside. The ESG angles come from drives to improve franchisees’ energy efficiency (through insulation, LED lighting and motion-sensitive detectors) and loyalty program incentives for re-using linens and towels. Taylor-Wolfe – who lost her brother to cancer – featured in the 2015 edition of The Hedge Fund Journal’s “50 Leading Women in Hedge Funds” report. She subsequently reportedly obtained USD 250 million of seed capital from pension fund CalSTRS. 

Gas and real estate related longs

Matthew Smith, founder and managing partner of Deep Basin Capital, picks winners and losers in the geographically segmented US natural gas market. Some players must compete with associated gas that has sometimes been negatively priced as it is a by-product of oil wells, while others have access to markets with much firmer pricing. And while some shale producers face sharply declining production, Cabot Oil & Gas has an asset in the Marcellus Shale (in the Appalachian Basin) that should last 18 years, increase its margins and free cash flow yield of 10%, and soon put the balance sheet into a net cash position. Cabot also owns part of a pipeline that transports the gas to an area of scarce supply. Smith views it as a potential takeover target with his upside share price scenario being USD 40.

Christopher Hansen, president and founding partner of Valiant Capital Management, expects a shift in Zillow’s business model could prove to be transformational. Zillow already offers an online real estate agency, and its iBuyer business is now buying up actual homes, based on an electronic valuation model, which has already garnered a 6% market share in Phoenix, Arizona. As iBuyer is rolled out across the US, Hansen expects that Zillow’s share price could quadruple or quintuple.

Leasing pairs trade

In two parts of the leasing market, Greenlight Capital’s president, David Einhorn, sees a wide valuation gap, which is the opposite of what he would expect based on his assessment of the relative fundamental merits of the businesses. He believes aircraft leasing is a more attractive business than railcar leasing. Air travel is a secular growth industry that has grown four times as fast as rail travel, where volumes are also cyclical – and threatened by the fashion for precision scheduled railroading (PSR), which sweats assets harder and reduces demand for railcars. Aircraft leases have longer lives and cover a higher proportion of costs than do railcar leases, and pent up demand for aircraft is reflected in order backlogs. The risks of intermittent airline bankruptcies are mitigated by security deposits, maintenance reserves and rent in advance. Einhorn is long Aercap, which he judges to trade at roughly half the valuation of GATX.

Multi-sector longs and shorts

Two speakers had a broader discussion across a range of sectors. Melvin Capital Management founder and CIO, Gabriel Plotkin, who featured in The Hedge Fund Journal’s 2014 “Tomorrow’s Titans” report, is short of some leveraged REITS burning cash with unsustainable tenant income; though he acknowledges that some higher quality REITs could stabilise. He is sceptical on Tesla, given that its competitors should soon get Federal tax credits, but has not shorted the stock. He expects that WorldPay should benefit from secular growth in payment networks and from its strong network and pricing power. Casino group, Las Vegas Sands, is another key short bet, based on growing gambling in Macau. D1 Capital Partners founder and CIO, Daniel Sundheim, views valuation as the biggest issue as the economy slows down, but reckons the Fed could ease rates as inflation is below 2%. He expects Netflix should break through USD 1,000 and go from being a super volatile stock to the most boring stock in the market, given its non-cyclical business model, price increases and growing subscriber base. He judges Canadian cannabis stocks to be a bubble. He views Amazon as having a constantly evolving business model with multiple revenue streams that have different margins, with AWS offering the most value, but thinks Alibaba could be better value. 

Macro views

Athanor Capital founder Parvinder Thiara trades all macro asset classes and geographies, including single name equities, but currently finds that Brazilian rates offer one of the most compelling opportunities. While the global growth slowdown means markets are discounting rate cuts in a number of emerging and developed market countries, Brazil is a real outlier where the market implies one of the most aggressive rate hike cycles in history. Yet Thiara believes that with Brazil’s economy still convalescing, and GDP 5% below its previous peak, a rate cut is actually more likely. He is long bonds on a currency hedged structure, which involves receiving two-year Brazilian rates and shorting the currency, using options, which he views as inexpensive. 

One speaker made the case for expressing a view on volatility rather than any directional trade. Sohn veteran, DoubleLine Capital CEO, Jeff Gundlach, views interest rate volatility as a good buy because US monetary policy could be in a state of flux. He recommends owning a straddle – call and put options struck at the same price – on US Treasury bonds, and suggests that they could reference the iShares 20+ Year Treasury Bond ETF. Gundlach is not alone in this call: Nancy Davis of Quadratic Management, who presented at the Sohn San Francisco conference in October 2017, launched an ETF this May – the Quadratic Interest Rate Volatility and Inflation Hedge ETF, which is designed to profit from heightened interest rate volatility.